In December 2008, IMF (Australia) – Australia’s largest litigation funder – reported that nearly 90% of the large-scale cases it was funding were class actions.1 The surge in IMF’s profits serves as an indication of the prolific growth in the number of class action proceedings in Australia since they first began in 1999. Indeed, legislative and common law developments over the last 20 years that have enabled shareholder class actions, toughened corporate disclosure requirements and allowed litigation funding in Australia, have provided fertile conditions for the growth of shareholder class actions.
So can the trend be expected to continue? What are the uncertainties which shareholders face in their class actions against corporations? And importantly, how can in-house counsel assist their organisations mitigate the risk of their companies becoming the target of a shareholder class action?
The growth of shareholder class actions
There are currently at least 30 major class actions underway or in contemplation in Australia. Many of them are on behalf of investors who purchased shares or other instruments in a company or managed investment scheme where the company had allegedly:
- published information which was misleading or deceptive;
- failed to disclose price sensitive information to the market; or
- acted in some other way in breach of its duties and responsibilities under the Corporations Act 2001 (Cth).
The investors claim they “lost money” as a result of investing in the shares after the relevant announcement was made. We refer to these actions as “shareholder class actions”.
Some recently commenced shareholder class actions include:
- Fincorp: a claim commenced on 24 August 2009 seeking damages arising out of the collapse of the fixed-interest investment scheme managed by Fincorp Investment Limited. Law firm Slater & Gordon estimated that “over $200 million invested by around 8,000 ‘mum and dad’ investors” had been placed at risk.2 The plaintiff investors allege that, in contravention of its obligations under section 283DA of the Corporations Act, Sandhurst failed to exercise due care, skill and diligence to ensure that Fincorp had, or had access to, sufficient funds with which to repay the amounts borrowed from investors.
- OZ Minerals: a claim commenced on 7 October 2009 against OZ Minerals Limited alleging that the company engaged in misleading and deceptive conduct in failing to tell the market it was due to pay debts of US$560 million by November 2008. This action is funded by IMF.3
- Centro: two separate class actions against the Centro Property group of companies (one by Maurice Blackburn and another by Slater & Gordon), both alleging misleading and deceptive conduct and breaches by Centro of its continuous disclosure obligations.
These recent actions follow on from numerous other high-profile shareholder class actions against prominent corporations, including:
- Opes Prime: a class action commenced on behalf of 50 clients of the failed stockbroking firm Opes Prime, as well as ANZ Banking Group and Merrill Lynch, alleging that clients entered what they thought were margin loan agreements having relied (at least in part) on misleading statements concerning the nature of those agreements. These proceedings have been resolved as a result of approval of a scheme of arrangement for all creditors. In addition to IMF, these proceedings are being funded by US litigation funder, Commonwealth Legal Funding LLC.
- Westpoint: an action against a number of financial advisors on behalf of approximately 2000 investors who lost money investing in the failed Westpoint finance schemes, as a result of being incorrectly informed that the investment was low risk, or even risk free. This class action is being funded by IMF.
- AWB: an action against AWB Limited on behalf of shareholders alleging that AWB was in breach of its continuous disclosure obligations under both ASX Listing Rule 3.1 and section 674(2) of the Corporations Act. The action also pleaded that AWB had engaged in misleading and deceptive conduct by concealing the true nature of its agreements with the Iraqi Grains Board. This matter was listed for hearing, commencing 30 November 2009. On 15 February 2009, counsel for the plaintiffs announced that the parties had reached an in principal $39.5 million settlement.4
Other prominent Australian companies that have been targets of shareholder class actions have included GIO, Aristocrat, Visy, Telstra and Multiplex. Future shareholder class actions are currently being contemplated against Great Southern, Octaviar and ABC Learning Centres. These examples are but a few.
So what has been the catalyst for the inexorable rise in shareholder class actions in Australia?
Australia – fertile ground for investor class actions
The introduction of court rules permitting class actions
The use of class action proceedings by investors and shareholders to seek damages for losses incurred as a result of breaches to corporate and trade practices law is a relatively recent phenomenon.
In 1988, the Australian Law Reform Commission (ALRC) published a report entitled Grouped Proceedings in the Federal Court (ALRC Report),5 which recommended the introduction of a class action model. The ALRC contemplated that this particular model could be utilised, for example, for misleading conduct actions by shareholders against corporations.6 However, despite the ALRC’s vision, it has not been until relatively recently that class actions by investors have become commonplace.
Based upon the ALRC Report, statutory provisions governing the commencement and conduct of class action proceedings were enacted as Part IVA of the Federal Court of Australia Act 1976 (Cth). The Act sets out the procedural requirements for a class action to be commenced and maintained.
To bring a class action under the Act, all that is required is that:
- 7 or more people have a claim against the same person;
- the claims are in respect of, or arise out of the same, similar or related circumstances; and
- they give rise to a substantial common issue of law or fact.7
It has been suggested that Australia has one of the most liberal class action regimes in the world,8 where class actions can be organised and commenced with relative ease.9 One of the particularly liberal features of the Australian class action regime is the minimal degree of commonality required between members of the plaintiff class. There is no need, for instance, that they share the same cause of action or the same loss. It is a lower threshold than even the United States, where, as Professor Geoffrey Miller has pointed out:
- Certification of a class action is required by the Court at the outset of a claim, without which a claim cannot proceed. The court must certify that:
– there exist common issues of law or fact;
– the claims of the class representative (the person commencing the proceeding on behalf of the class) are “typical” of the claims of the class;
– the representative is an adequate representative of the class;
– joinder of individual claims is not feasible; and
– the common issues predominate over any individual issues.
As a consequence, the US courts are required to launch into a hearing at the interlocutory stages exploring aspects of the merits of the claim which would not otherwise need to be dealt with until a final hearing. No such threshold requirement exists in Australia.
- While both jurisdictions compel the proponent of a class action to notify all class members of the proceedings and their entitlements in relation to the action, and in particular the entitlement to “opt out” of the proceedings, the US requirement is more onerous in that it requires notice to be delivered by first class mail. This is in contrast to Australia where generally notice can be given in the form of a publication.10
Continuous disclosure requirements
It was not only the ability to bring class actions but the increased scope for matters to litigate upon which has led to the rise in class actions. The introduction of continuous disclosure requirements in 1994 have been a significant factor in explaining this growth, as allegations of breaches to the requirement for continuous disclosure have been a common thread in many of past, present and anticipated class actions.
Continuous disclosure requirements have subjected corporations to significantly more onerous obligations to ensure that the market and shareholders are kept informed of information which is material to the corporation’s financial circumstances, performance and forecasts.11 To avoid engaging in misleading conduct, corporations have had to balance the need for the sufficient and timely disclosure of information against the risk of premature or incomplete disclosure in a commercial setting.
The impact of the Sons of Gwalia decision
The scope for litigating disclosure obligations was significantly widened by the decision of the High Court of Australia in Sons of Gwalia Ltd v Margaretic,12 which opened the door to a whole stream of potential class actions by shareholders previously thought to be doubtful. However, the opportunity to take advantage of the Sons of Gwalia decision may be shortlived. On 19 January 2010, the Minister for Financial Services, Superannuation and Corporate Law, The Hon Chris Bowen MP, said that the Government would amend the Corporations Act to reverse the effect of the High Court’s decision.13
Sons of Gwalia Ltd, a publicly listed company, was placed into administration on 29 August 2004. Less than two weeks earlier, Mr Margaretic purchased 20,000 shares on-market. Upon the appointment of the administrator, the shares became worthless.
In addition to several other claims, Mr Margaretic alleged that the company had breached its continuous disclosure obligations14 and had engaged in misleading and deceptive conduct.15
The central issue to be decided was, assuming that there had been misleading or deceptive conduct by the company, could shareholders claim damages from the company in which they held shares when, together, they theoretically constituted the company itself? Did that not mean that the shareholders were in effect claiming damages from themselves?
In particular, in an insolvency scenario where the interests of creditors are intended to prevail over those of members, there was a question over whether this was a claim to which section 563A of the Corporations Act applied. Section 563A provides that the:
“Payment of a debt owed by a company to a person in the person’s capacity as a member of the company, whether by way of dividends, profits or otherwise, is to be postponed until all debts owed to, or claims made by, persons otherwise than as members of the company have been satisfied.”
To resolve the issue, the administrator of Sons of Gwalia sought declarations from the Federal Court that a claim by a member such as Mr Margaretic’s was not provable in the deed of company arrangement, or alternatively that payment of the claim should be postponed until all debts owed to persons other than members are met. Mr Margaretic cross-claimed for a declaration that his claim for compensation for misleading and deceptive conduct made him a creditor and, as such, he was entitled to plead as a creditor for the debt owing to him by reason of the company’s conduct. Mr Margaretic’s claim was funded as a test case by IMF.
Both the Federal Court at first instance, and the Full Federal Court on appeal, held that Mr Margaretic’s claim was not based upon any rights or obligations arising from his membership of the company, or by virtue of the corporate contract between himself and the company. Rather, his claim was based independently on a statutory right, under the Trade Practices Act 1974 (Cth) and other legislation.
The High Court dismissed an appeal from this decision and confirmed that the creditors’ first-in-line priority provision in section 563A of the Corporations Act did not preclude a shareholder from making a claim against the company in administration, for damages sustained by acquiring shares as a result of a reliance on misleading or deceptive conduct by the company.
A shareholder class action ensued on behalf of all members who had bought shares in the period leading up to the entry of the company into administration. It was conditionally settled in September 2009.
The effect of the Sons of Gwalia decision was to enable shareholders to make claims for damages against corporations, for breaches of their statutory obligations to properly disclose information to the market. With this development, and the liberal new class action rules in the Federal Court, the conditions permitting shareholder class actions to flourish were established.
With the Commonwealth Government’s announcement of its intention to reverse the Sons of Gwalia decision, it is not yet clear what impact this reform will have on the opportunity for shareholder class actions, particularly as no proposed legislation has been presented to Parliament as yet. However, as the opportunity for shareholder class actions may be curtailed in insolvency contexts, the focus for shareholder class actions in the future may change towards other director’s obligations and areas of corporate governance.
The interrelationship between litigation funding and class actions
Courts say “yes” to litigation funding
With the liberalisation of class actions rules, and the introduction of continuous disclosure obligations providing ample opportunities for shareholder class actions, a key hurdle was who would fund them.
This question was partly resolved with the passage of the Maintenance, Champerty and Barratry Abolition Act 1993 (NSW). The Act abolished the common law offence of maintenance and champerty16 and abolished maintenance and champerty as an action in tort, thereby establishing new possibilities for the funding of litigation.17
However, section 6 provided that the Act did not affect any rule of law as to the cases in which a contract is to be treated as contrary to public policy or as otherwise illegal. This meant that it was still possible that arrangements for the funding of litigation could be challenged on public policy grounds.
It was not until 2006 that the question of the legality of litigation funding was tested by the courts. In Campbells Cash and Carry Pty Limited v Fostif Pty Limited,18 the High Court had considered whether litigation funding should be seen as an abuse of process or as being contrary to public policy.
The defendants argued that the litigation funding arrangement was an abuse of process – that it amounted to “trafficking in litigation” – and asked that the proceedings be stayed. The defendants were also critical of the control that could be exercised by the the funder over the interest of the indvidual retailers and the prospect of the emergence of a secondary market in litigation.
In the opinion of the trial judge, the funding arrangement was an abuse of process. However, a majority of the High Court disagreed.19 By majority, the High Court held that:
- since the abolition in New South Wales of the torts of maintenance and champerty, a funding arrangement does not itself give rise to public policy considerations justifying a stay;
- there was no rule of public policy that prohibited an agreement to provide money to a party to institute or prosecute litigation in return for a share of the proceeds of the litigation, even where the agreement enabled the funder to exercise control or share in the reward;
- it was not surprising that the person who funds litigation expects to exercise some control over the litigation.
The High Court thus removed much of the uncertainty surrounding the legitimacy of litigation funding.
The consequence was (predictably) a significant expansion of the availability and use of litigation funding. As observed in the introduction to this article, the number of high profile shareholder class actions has escalated rapidly over the past three years. There was, it seemed after Campbells Cash and Carry, nothing that might arrest the growth in this burgeoning field. IMF’s share price surged 150%.
Multiplex: A dead-end or a bump in the road?
The relative freedom of litigation funding and the certainty that had existed since Campbells Cash and Carry has been somewhat bridled following the decision of the Full Federal Court in Brookfield Multiplex Ltd v International Litigation Funding Partners Pte Ltd20 on 20 October 2009.
In December 2006, class action proceedings were commenced against Multiplex Limited on behalf of all security holders who purchased or acquired an interest in Multiplex securities during the period 2 August 2004 and 30 May 2005 (and who had entered into a Funding Agreement with International Litigation Funding Partners Pte Ltd). The plaintiffs alleged that Mutliplex breached the continuous disclosure provisions of the Corporations Act and engaged in misleading or deceptive conduct, by failing to properly disclose the full extent of cost increases and delays in the construction of the Wembley National Stadium and the impact these matters would have on Multiplex’s earnings forecast.
Multiplex commenced separate proceedings (Brookfield Multiplex Ltd v International Litigation Funding Partners Pte Ltd (No 3)21) in the Federal Court against the litigation funder, alleging that the litigation funding arrangement and the solicitors’ retainers constituted a managed investment scheme within the definition in section 9 of the Corporations Act. This, they said, meant it was required to comply with Chapter 5C of the Act, including that the arrangement would need to be registered with ASIC and that a “responsible entity” would be appointed to manage it. Operating a managed investment scheme without complying with these obligations is unlawful.22
By a 2-1 majority, overturning the decision of Justice Finkelstein at first instance, the Full Court held that the litigation funding arrangement and the solicitors’ retainer agreement did have the necessary elements to constitute a managed investment scheme, and as such it should have been registered.23 It remains to be seen whether this issue will rest there, or whether (as seems likely) it will attract the attention of the High Court.
Amongst other implications, one consequence of the ruling is that litigation funders or class action lawyers, in order to be appointed as the responsible entity of a managed investment scheme, will need to hold a financial services licence.
This development could be significant for the litigation funding industry. The litigation funder, IMF, the only litigation funder which currently holds a financial services licence, has stated that in light of the court’s finding, the following alternatives are available to it:
- making an application to ASIC for an exemption from the requirement to register class actions as a managed investment scheme;
- in the absence of such an exemption, registering each class action arrangement as a managed investment scheme; or
- including only sophisticated investors as members of each class.24
In addition to considering these options, other funders will also have to become holders of financial services licences.
It is clear, however, that resolutions to these litigation funding developments will no doubt have an impact on whether the trend of increasing shareholder class actions will continue.
The unanswered question: Damages and causation
While court rulings and legislative reform have established the certainty needed for a stable foundation for shareholder class actions, there remains one area that is open to significant uncertainty and doubt. It is, perhaps, the last significant hurdle to be overcome by plaintiffs in deciding whether to launch a shareholder class action.
As we have discussed, shareholders who suffer loss or damage as a result of misleading disclosures to the market are entitled to sue for compensation. The question is: how can a shareholder prove the necessary causal connection between a misleading or deceptive market disclosure and the loss or damage that they have suffered? Further, where the action against the corporation is brought as a class action, does each and every member of the class separately need to prove their own loss and damage and their own causal connection? Or is there some way in which a Court can shortcut this process and say that loss or damage must have flowed from the contravention, so that proof of causation is not strictly necessary?
All of the shareholder class actions brought in Australia to date have resulted in discontinuance or settlement. None has led to an award of damages by the Court. With the anticipated settlement of the AWB matter, another opportunity for judicial guidance on the this issue has been put to one side. In Aristocrat,25 the vexed causation issues were canvassed and debated in detail. They were the subject of lengthy submissions. A final judgment in Aristocrat, had it ever been issued, would have been a useful first step to resolving the damages conundrum. However, the parties reached a settlement after the hearing but before the damages judgment was delivered, thereby the Court was unable to provide any guidance on these matters.
Indeed, guidance from a first instance decision will be important, but it will not finally resolve the issue. Until there is a decision that finds its way to the High Court, it is expected that questions about damages in shareholder class actions will remain uncertain and unresolved.
Why is the question of damages and causation so vexed?
In demonstrating the difficulties posed by the issue of damages and causation it is useful to outline a hypothetical scenario. Consider the scenario where Corporation X informs the market that it has identified a drug that cures some forms of cancer, and has applied for and expects to receive approval from the Therapeutic Goods Administration (TGA) to market the drug in Australia. Upon making that announcement there is a significant increase in the share price for Corporation X.
However, when this market disclosure was made, it was in fact untrue. The drug is in its early stage of research and development, it may or may not be a cure for cancer, and in any event, approval by the TGA is a distant and doubtful prospect.
About three months after the making of the market disclosure, these circumstances are discovered by Corporation X’s general counsel. She advises Corporation X that a corrective disclosure is required, and Corporation X complies. The share price drops rapidly; initially, to a price well below the prevailing price prior to the original disclosure. However, the share price eventually stabilises at a level that is somewhat higher than the original price but still far short of the average price during the three month period in which the market was trading on the basis of the false information.
Shareholders of Corporation X are affected by this scenario in diverse ways. Here are some examples.
Shareholder 1 – the prudent investor
The prudent investor is in his mid-30s, has a stable income, and is a contributor to a self-managed superannuation fund. He has an investment advisor who has recommended, on the strength of the announcement of the discovery of the new drug, that he heavily invest in Corporation X shares. Shareholder 1 follows the advice and invests in the shares shortly after the market announcement, when the shares have increased significantly in price. Shareholder 1 pays, so to speak, at the top of the market, in the expectation that the share price will increase even further when the expected TGA approval is received. When the corrective disclosure is made to the market, and the share price falls to below its original value, Shareholder 1 sells to cut his losses. He sells at the bottom of the market.
Plainly, Shareholder 1 has relied on the initial, incorrect market disclosure, as well as the corrective market disclosure. He has suffered a significant loss. His loss is the difference in share price between the top of the market following the original disclosure, and the bottom of the market following the corrective disclosure, multiplied by the number of shares he purchased and subsequently sold. Shareholder 1 has a strong claim for damages against Corporation X.
Shareholder 2 – the slow mover
Like Shareholder 1, Shareholder 2 was encouraged by Corporation X’s market disclosure about its promising new cancer-fighting drug. Unlike Shareholder 1, however, Shareholder 2 took her time before making the investment – it was made about a month after the announcement. The share price at that time was no longer as high as it was immediately after the announcement, but it was still significantly higher than the prevailing price before the announcement. Then, when Shareholder 2 sells, she does so four or five months after the corrective announcement. By that time, the share price has risen somewhat from its lowest point, which was hit in the days after the corrective announcement. In fact, the share price has now risen to somewhere slightly above the prevailing price prior to the original announcement.
Shareholder 2’s loss is of much smaller magnitude than Shareholder 1’s. It is calculated in the same way – the difference between the price paid when the shares were bought and the price paid when they were sold – but the price paid was lower than Shareholder 1’s, and the sale price was higher, so the difference (representing Shareholder 2’s loss) is much smaller.
A key question for Shareholder 2 is: did she rely on either the original market disclosure or the corrective market disclosure? Perhaps she did, but she relied on much else as well. By the time she bought – and again, by the time she sold – a good deal of other information was in the market. There have been other developments which have caused the price to go up and to go down.
Shareholder 2 may have a reasonable claim for damages against Corporation X. However, in calculating the quantum of those damages, Corporation X might seek to argue that share price movements caused by factors other than the initial, misleading, announcement and the subsequent corrective announcement should be removed from the damages calculation. Corporation X might argue that a so-called “market study” – an econometric analysis of exactly what factors are causing each price movement – needs to be performed so that the Court can limit the damages payable to those share price movements attributable to the offending conduct of Corporation X.
Shareholder 3 – the long term investor
Shareholder 3 bought stock in Corporation X when it was first listed at 20¢ per share five years ago. Slowly the price increased to 50¢. Shareholder 3 thinks now is a good time to sell his shares and take the profit. However, when the announcement of the new drug discovery is made, the share price doubles to $1 overnight. Shareholder 3 decides to hold his shares a bit longer. Later, after the corrective announcement, the market drops suddenly. The share price plummets to 20¢. Shareholder 3 sells quickly, so that at least he can get out of the deal breaking even, rather than taking a loss. However, in the months after he sells, the share price creeps up again to 60¢. Had he held on a little longer, Shareholder 3 could have sold at a 10¢/share profit.
What is Shareholder 3’s loss? Shareholder 3 relied upon the announcement of the drug in deciding not to sell at that time, as he had originally intended. He lost the opportunity of earning a profit of 80¢ per share. On the other hand, had the misrepresentation not been made by Corporation X in the first place, the share price would never have spiked, so his real loss is not 80¢ but the difference between what the share price would have been, absent the incorrect market announcement, and the price at which Shareholder 3 sold. That is a matter of some considerable speculation. It may be that Shareholder 3 would have made less profit in that scenario than the 10¢ he in fact made. Further, he might have sold at a different time – either earlier or later – and therefore escaped the bottom of the market and made little loss or none at all. The arithmetic of the loss calculation for Shareholder 3 is very difficult indeed. Again, there may be a need for an econometrician to try and isolate the various causes of movements in the share price of Corporation X during the relevant period. The calculation for Shareholder 3, however, will be for a different time period than the analysis for Shareholder 2.
These examples illustrate the difficulty in working out the loss suffered by a group of shareholders, all of whom have been affected, one way or another, by the company’s misleading or deceptive conduct. How is a Court to begin the exercise? There is no “one size fits all” formulation that will correctly compensate all of these shareholders for their respective losses. On its face, there surely does not seem to be an alternative other than for the court to separately hear and determine the damages claims of each and every class action plaintiff.
However, there are cases that still further confound the causation question.
Shareholder 4 – the unlucky home trader
Shareholder 4 did not read any of the announcements by Corporation X. The wife of a friend of somebody he met at the pub said he had a hot tip, and Shareholder 4 acted on it. He bought Corporation X shares at the top of the market. He has never sold them. He still holds them, but they are now valued at less than half the price he bought them.
On one view, Shareholder 4 is not even entitled to participate in the securities fraud class action against Corporation X. He did not even know that there was a company announcement, much less did he rely upon it. On the other hand, it could be argued that he has suffered a loss because, had the misleading representation not been made, he would have paid far less for the shares than he in fact paid? The misleading representation “caused” his loss in the sense that it caused the market to be inflated at a time when he happened to be a buyer. Is that a sufficient link? Or does there need to be actual reliance upon the misleading representation?
Shareholder 5 – the hedge fund
The hedge fund has held futures in Corporation X shares for some time, and now wishes to lay off some of the futures risk by acquiring physical shares. It does so at the top of the market, following the misleading market announcement. But the fund has little interest in the share price movement – any increase in the price of Corporation X shares will be offset by a reduced profit (or a loss) on the futures contract, and vice versa.
Has Shareholder 5 suffered any loss at all? Does Shareholder 4’s argument apply to Shareholder 5? At least Shareholder 4 was able to say that he paid “too much” because Corporation X’s misleading conduct had caused the market to be artificially inflated. However, is there any basis on which it can be argued that Shareholder 5 paid “too much”?
What options do the courts have for dealing with securities class action damages?
Drawing on the case law, arguable courts have a range of options in resolving the issues concerning the calculation of compensation in class actions.
The most obvious and correct option, from a strict legal perspective, is for the court to accept that every member of the group of plaintiffs has a different damages and causation case, even if liability questions can be answered on a joint basis. Therefore, the court has no alternative but to consider each of the damages claims separately. However, there are signs that the courts may be reluctant to accept that approach.
At a directions hearing in August 2009, in response to a submission that every one of the 20,000 plaintiffs in the class action against Amcor and Visy had a different damages claim, Jacobson J of the Federal Court said:
“‘Do you expect me to hear 20,000 cases before I retire? One case is going to have to resolve a lot of the issues…’” 26
It is easy to see why, despite the real legal and economic challenges, a trial court would be attracted to finding a shortcut. The question is whether any shortcut would be correct.
There are at least three possible “shortcuts” that emerge from the cases.
The first is what might be termed “inferred reliance”. An early case under section 52 of the Trade Practices Act, Gould v Vaggelas,27 held that there are certain kinds of documents – for example, a prospectus – that are issued for the express purpose of being relied upon in a decision to purchase securities. It follows, that it may be inferred, at least on a presumptive basis, that anyone in the market who purchased securities after the issue of the prospectus to the market did in fact rely upon it. The presumption is rebuttable, but the onus shifts from plaintiff to defendant. If the defendant corporation can prove that a particular plaintiff did not rely on a misleading market disclosure then the presumed causation falls away.
The second possibility has been referred to as the “indirect causation” argument. This arises from the NSW Court of Appeal decision in Ingot Capital.28 The Court said that, in the typical case, a plaintiff suffers loss only if he or she actively does something in reliance on the misrepresentation. However, as an exception, there is another class of cases where a loss can be suffered even if the plaintiff is passive. An example is where a company which sells a particular product engages in misleading advertising and its rival thereby loses market share and hence profit. The rival did not rely upon the misrepresentation, but can nevertheless sue for the lost profit.
If a shareholder can demonstrate that it suffered this kind of “passive loss” will it, similarly, be awarded damages? In practice, demonstrating “passive loss” will be difficult, as the Ingot Capital case showed. The argument made there was that, absent misleading advice given to the board, the company would not have issued a misleading prospectus and hence the investor plaintiffs would not have purchased certain ill-fated securities. However, the argument was rejected; the Court held that a sufficient causal nexus had not been established. The argument would have allowed recovery of damages by shareholder plaintiffs who had not suffered a loss in reliance on any misrepresentation.
The third possibility is known as the “fraud on the market” theory and reflects the approach taken in the United States. The fraud on the market theory is based upon the principle that the prices for securities in efficient securities markets always takes into account all of the available information. When incorrect information about a company is released to the market, that information affects the company’s share price. If that information causes the price to increase, then the entire market has effectively been misled into trading at an inflated price. Anyone who buys at that price has paid too much, and in that sense has suffered a loss. It may be that this is nothing more than another way of putting the indirect causation argument. Nevertheless, it is one legal option that, for some, has the attraction of being simple, and being supported by established economic theory (the efficient market hypothesis). In the fraud on the market approach, a plaintiff need only show that the misrepresentation by the company was price sensitive, and that he or she bought securities after the representation was made and before it was corrected.
Despite these attractions, the approach has shortcomings: both shareholders 4 and 5 in the examples above would be awarded damages, even though they do not appear to have suffered a loss that can meaningfully be said to be causally connected to the offending conduct of the corporation (and in the case of shareholder 5, they have suffered no loss at all). Their damages will be a windfall gain at the expense of Corporation X. It is directly contrary to the longstanding common law preference to avoid damages awards that result in over-recovery.
Moreover, the fraud on the market approach does not remove the need for econometric market studies to remove the price effects of matters other than the offending misrepresentation. As the examples of shareholders 1, 2 and 3 show, market studies will yield different results for each of them, so there is a real question whether the fraud on the market approach will be quicker or cheaper in assessing damages than taking a plaintiff-by-plaintiff approach.
Finally, there is also the question whether the fraud on the market theory has a sound basis in the first place. There is currently real debate – including in the US – about whether securities markets are actually as efficient as economic theory assumes they ought to be. Information is disseminated and absorbed imperfectly. The price of a security may not always reflect the value that is theoretically dictated by the available information.
For all of these reasons it will be a significant step for a court to depart from traditional common law principles in relation to damages and causation. At the end of the day, this may prove to be the most significant deterrent of all to the commencement of a large securities class action. It will take a defendant with the courage to proceed to judgment – and to run the gauntlet of two appeals – for an answer on how damages and causation should be calculated in class actions.
The message for in-house counsel
Shareholder class actions have arrived. They may ultimately prove to be as effective an incentive to comply with the Corporations Act as the threat of ASIC enforcement actions – and perhaps more so.
Importantly, how do officers and directors of public companies avoid finding their company on the receiving end of a well-funded class action brought on behalf of a large number of individuals? Individually the claims may be small, but collectively, the suit may involve a very substantial claim.
The best advice is to implement procedures and compliance practices to minimise the risk of allegations of continuous disclosure breaches being made. Written policies and procedures concerning disclosure must be established – and followed.
If a threat of a shareholder action is made, move quickly to develop a strategy. Whilst opportunities for challenging class actions are becoming more limited, they do still exist; as the Multiplex decision has demonstrated and the Aristocrat proceedings foreshadowed. Does the defendant corporation wish to invest the time and legal expense necessary to take advantage of these opportunities? If so, this is a decision to take early. Alternatively – or in parallel – a corporation should be attuned to potential settlement options. Settlement opportunities arise frequently in shareholder class actions, and in some cases they occur earlier rather than later in the legal process. Corporations would be well advised to avoid “riding out the storm” while shareholders are being canvassed and corralled into plaintiff groups or early settlement opportunities may be missed.